How does a Construction Loan Work?


Although building a custom home may seem like a daunting undertaking, If you have a professional on your side who knows the in's and out's of construction financing, you will be way ahead of the game.

A construction loan has many similarities to conventional financing as well as some distinct differences. Unlike traditional financing the entire project is taken into account prior to a lender approving or denying your loan request.

In addition to the credit approval process you must go through as a potential borrower, the Builder of your home must also qualify under the specific lender guidelines. These guidelines are created to insure the builder of your home is licensed, has experience in doing the type of project applied for and is insured. Lender guidelines concerning the builder of your project are designed to minimize the risk for both you and the lending institution.

During the project approval process the lender reviews your financial ability to complete the project as well as the plans, specs, build costs and appraised value of property. A draw schedule against the loan amount is selected which fits both you and the builders requirements for the project.

During the actual construction process, you are only required to make interest only payments on the amount of funds you have drawn.  In some cases an interest reserve account is set up so that out of pocket payments are eliminated during the construction time period.

Construction loans are typically variable rate loans  with specific terms of completion ranging between 6, 12 & 18 months. Upon completion of the project these loans typically come due and require either a time extension at a cost or pay-off of the construction loan with permanent financing. Just make sure you allow for the inevitable construction delay.

Another Variable in construction loans is how much of the project cost the lender is willing to lend. If you already own the land, ten that can be considered as equity on the construction loan.

Many Home builders  avoid the two step process of the construction loan & "Take out" loan by securing a construction-to-permanent or one time close  financing up front. Allowing the borrower to qualify for both the construction and permanent financing at the same time.